What is a Pay-to-Play Provision?

In February of 2023, Sequoia made headlines when they walked away from their investment in crime tracking app, Citizen, after being offered a “pay-to-play” deal by the company. These provisions, while common after the dot-com bubble burst in the early 2000s, had fallen out of favor in recent years, given the strong economic outlook for startups.

However, in a down market, startups may have trouble raising financing. As such, they’re more likely to turn to pay-to-play provisions, which can have serious consequences for the company’s existing investors. In this guide, we’ll break down pay-to-play provisions for VCs, including what they are, why companies use them, and guidance for investors facing a pay-to-play provision.

What is a Pay-to-Play Provision?

Pay-to-play provisions are financing mechanisms that incentivize existing investors (also known as "limited partners" or "LPs") to participate in a new financing round. Investors are incentivized by having the economic rights, privileges, and obligations they agreed to during the previous investment round (e.g., liquidation preferences, share class, pro rata rights, etc.) modified based on whether or not they decide to invest in the new financing round. Typically, an investor will be required to invest their full pro rata amount (based on the investor’s existing percentage of ownership), but certain pay-to-play provisions may allow for partial participation.

Pay-to-play modifications can take the form of either a punishment or reward for investors, generally at the startup’s discretion. A typical punishment-focused pay-to-play provision is the “compulsory conversion of shares,” whereas a typical reward approach is a “pull-through” or “pull-up” transaction.

• Compulsory conversion of shares: This approach converts an existing investor’s preferred stock into either common shares or a less favorable class of preferred shares if the investor does not satisfy their pro rata share of new financing. The company can impose this modification on all shares held by the non-participating investor or a portion of their shares. For example, if the investor only invests 50% of their pro rata in the new round, the company can decide to implement the modification on 100% of the investor’s shares (because the investor did not invest their full pro rata amount) or the company can decide to only implement the modification on 50% of the investor’s previous holdings.‍
• Pull-through or pull-up transaction: Rather than punish investors for not participating in the new financing round, a pull-through or pull-up approach rewards investors by allowing them to essentially exchange their existing preferred shares for a new class of preferred shares with superior terms (e.g., higher liquidation preference). A pull-through pay-to-play provision has the simultaneous effect of benefitting investors who decide to participate in the financing round while disadvantaging investors who don’t participate, given their preferred shares will now be subordinate to the new class of preferred shares. Similarly, the company can decide whether to require full or partial pro rata participation to benefit from the pull-through.

Why do Companies Include Pay-to-Play Provisions in Their Term Sheets?

Companies typically turn to pay-to-play provisions when they’re struggling to raise capital.

During the bull market of the early 2020s, when funding was relatively easy to come by, companies generally didn’t need to use pay-to-play provisions to incentivize existing investors to re-invest. On the contrary, investors often negotiated to secure pro rata rights in future financing rounds, to ensure they could maintain their equity stake in the business.

However, in a downturn, VCs may be more reluctant to invest, particularly if the company is seen to be struggling. As such, founders may opt to utilize pay-to-play provisions to ensure they can secure additional funding for the company.

What Should You do When Faced With a Pay-to-Play Provision?

As an investor, if you’re sent a term sheet that includes a pay-to-play provision, it can be important to identify the term quickly and seek legal counsel as necessary to understand the exact details of the provision (i.e., if it’s a compulsory conversion of shares or pull-through approach). Identifying a pay-to-play at the onset of a financing round can allow you to more readily identify your next steps, whether that be negotiating with the founder or allocating capital to invest.

Generally, deciding whether to participate in a pay-to-play round depends on your outlook on the company. An investor who is bullish on the long-term potential of the business may participate in a pay-to-play round, whereas an investor who has cooled on the business may choose to pass on the investment and simply incur the consequences of the pay-to-play provision. Depending on relative bargaining power, investors may also feel empowered to push back on a pay-to-play provision, if they feel it’s overly putative.

For founders considering a pay-to-play provision (especially during a market downturn), consider how you can pitch the pay-to-play provision to investors in a way that’ll make them more amenable to a harsher consequence for non-participation in a future financing. For instance, it might help to communicate how you plan to navigate the down market, so investors are more confident in the long-term outlook of the business.

Remember: investors want their portfolio companies to succeed. Selling them on a long-term vision when the going gets tough may make a pay-to-play provision easier to stomach.

AngelList Relay Helps VCs Stay on Top of Pay-to-Play Provisions

AngelList Relay is an AI-powered portfolio analyzer that can help flag off-market terms, including a pay-to-play provision, in certain investment documents. VCs simply need to set up an AngelList Relay account and email, then forward investment documents to their AngelList Relay email. Relay will extract key information from the investment documents and organize them as structured data in an investment dashboard. This allows VCs to quickly identify and address pay-to-play provisions.

To learn more about AngelList Relay, visit our website.